Question: Assume stock returns are explained by a two-factor model as follows: R i = 0 + i1 * 1 + i2 * 2 The following

  1. Assume stock returns are explained by a two-factor model as follows:

Ri = 0 + i1*1 + i2*2

The following three stocks are in equilibrium.

Stock

Return %

Beta 1

Beta2

U

10

0.6

0.8

V

16

1.6

1.8

W

15

1.8

0.9

  1. Derive the equilibrium model equation.
  2. Assume there is stock J with beta 1 of 1 and beta 2 of 1.2. Stock Js rate of return is 14.4%. Is stock J in equilibrium? If not determine an arbitrage strategy and calculate the arbitrage profit. Show the proper weight of each stock.

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